A partnership is an association between two or more parties for a for-profit business purpose. Partnerships are highly adaptable in organization ranging in spectrum from very simple to highly complex. This is because the business element is broadly defined by state law and the parties to a partnership are permitted to be individuals, groups of individuals, companies, corporations, trusts, limited liability companies and other types of organizations. Traditionally, in the context of a partnership, each partner shares directly in control of the business enterprise and in its profits and losses. The consequence of this profit sharing is that partners are jointly and independently liable for the partnership’s debts and obligations.
Creation, operation and dissolution of a partnership is governed pursuant to state law. Many states have adopted the Uniform Partnership Act (see, Massachusetts adoption at Massachusetts Uniform Partnership Act). Generally, a partner relationship results from a contract, either express or implied, with no formal requirements such as a signed document or Secretary of State filing, as is necessary to create a corporation. The determination as to whether a partnership exists is made by considering the intention of the parties, the sharing of profits and losses, the joint administration and control of business operation, the capital or time investment of each partner and common ownership of property.
In the context of a general partnership, partners are personally liable for torts committed by the partnership, its partners and its agents. This is not so in the case of a limited partnership, a type of business organization created by statute. Limited partnerships are governed in many states by the Uniform Limited Partnership Act (see, Massachusetts adoption at Massachusetts Limited Partnership Act).
Types of Partnerships
General Partnership. A general partnership is a partnership of the type described above. Each partner takes part in the management of the business and also takes responsibility for the liabilities of the business. If one partner is sued, all partners are held liable. General partnerships are the least desirable form of association for this reason.
Limited Partnerships. Limited partnerships are entities created by statute. To organize a limited partnership one must complete a filing with the Secretary of State. A limited partnership has both general partners and limited partners. Limited partners do not participate in the day-to-day management of the partnership and his or her liability is limited to the amount he or she invested in the partnership. The limited partners are merely investors who do not participate in the partnership other than to provide an investment and to receive a share of the profits. In fact, limited partners can lose their limited liability protections if they participate in the business activities of the limited partnership. The general partner or partners who actively oversee and participate in the business activities of the limited partnership continue to have unlimited liability for the debts and obligations of the limited partnership. Often, a corporation with limited assets is organized to serve as the general partner of the partnership. This arrangement is a bit clunky and in many cases has become obsolete by the advent of the limited liability company. Venture capital funds are commonly organized as limited partnerships.
Limited Liability Partnerships. A limited liability partnership (LLP) is different from a limited partnership or a general partnership. Its character is more closely aligned with the limited liability company (LLC). In the LLP, all partners possess limited liability protections. An LLP combines characteristics of partnerships and corporations. As with a corporation, all partners in an LLP have limited liability, from errors, omissions, negligence, incompetence or malpractice committed by other partners or by employees. However, any partner involved in wrongful or negligent act is still personally liable, but other partners are protected from liability for those acts.
In recent years, the limited liability company has supplanted each type of partnership, because of the limits of liability for one and all. There continue to be circumstances where a limited partnership or a limited liability partnership is quite useful. For example, venture funds continue to organize a limited partnership as their investment vehicles rather than limited liability companies because Canada taxes limited liability companies as a corporation rather than a partnership. As such, the limited liability company does not receive the same beneficial tax treatment as a limited partnership. Additionally, not every state permits certain types of business to be conducted under the umbrella of a limited liability company. For example, California does not permit limited liability companies to provide professional services.
Federal Income Taxation. For Federal and state tax purposes, a partnership is not itself a taxable entity. A partnership does not pay income taxes directly to the Internal Revenue Service (IRS). Instead, each partner is taxed on their share of the income and loss of the partnership on their personal tax returns. The partnership files an information return on Form 1065, showing the total amount of income and expenses and other deductions, the net income of the partnership and the share of that income for each partner. In addition to Form 1065, the partnership also prepares a Schedule K-1 for each partner which breaks down the partnership income into the appropriate share of income for that partner along with other information. The Schedule K-1 is filed with the partner’s personal income tax return, and the amount of income or loss is included with the partner’s other income. This is how partners pay income tax on their share of the partnership’s income at the applicable personal tax rate for the year. It should be noted that a partner is taxed on his or her distributable share of the partnership’s income not distributed income. The fact that the partnership may not have in fact distributed this income is irrelevant. The partner pays income tax on his or her share even if the partnership maintains the funds for business growth or some other reason.
Self-Employment Taxes. Partners are considered to be self-employed rather than employees. Each partner is required to pay self-employment taxes based on the information provided on Schedule K-1 indicating his or her share of the partnership income. Self-employment tax is included in each partner’s Form 1040 for Federal taxes, calculated using Schedule SE, and the total self-employment tax liability is included on Form 1040.
Other Employment Taxes. If a partnership has employees in addition to the partners, the business will be required to pay employment taxes, including withholding and reporting Federal and state income taxes, paying and reporting FICA (Social Security and Medicare) taxes, worker’s compensation taxes and unemployment taxes.
A partnership agreement sets out all the terms and conditions agreed to by the partners. In this document, every possible contingency should be considered and addressed. A partnership agreement should generally include the following information. Of course, the circumstances of each individual business venture will require the omission of certain of the considerations discussed below. Other situations will necessitate the inclusion of topics not included here.
Organization of the Partnership. At a minimum, this section of the partnership agreement should set forth the date of formation of the partnership, the statute or laws under which it was organized and the legal name of the partnership. If the partnership is anticipated to conduct business under a name other than its legal name, this fact should also be included in the partnership agreement.
Term of the Partnership. A partnership may be established for a specific time period or for the purpose of completing a particular undertaking. If this is so, the term of the anticipated life cycle of the partnership should be included in the partnership agreement.
Purpose of the Partnership. It is important to set forth the purpose or purposes for which the partnership was established. It is often a good idea to include language to the effect of the following rd text: “The Partnership is organized for the purpose of investing in start-up businesses in the metro-Boston area. Upon the written approval of the managing partner, business shall also be authorized to carry on any other business activity for which a limited partnership may be authorized under the laws of the Commonwealth.”
Admission to Partnership, Expulsion. The process of admitting a partner to the partnership should be outlined. In addition to becoming a party to the partnership agreement, the partner is often required to execute a subscription agreement in exchange for his receipt of an ownership interest. Many partnership agreements provide that certain delineated actions or omissions will result in a partner’s expulsion from the partnership. Engaging in an activity which is in competition with the business of the partnership is a common example of a prohibited activity which might result in expulsion. Penalties associated with expulsion may include a reduced valuation in the repurchase of the expelled partner’s interest or a complete forfeiture of his or her partnership interest.
Partner Contributions. The contributions of each partner must be a primary consideration in the preparation of the partnership agreement. The partnership may permit all manner of contribution by the partners including cash, property (including intellectual property) and services.
If partners will be permitted to defer their cash contributions, the agreement should detail how this deferral will be handled. A deferring partner may deliver a promissory note in the amount of his deferred contribution to the partnership. In this scenario, the partnership agreement sets forth the terms of the contemplated promissory notes including rate of interest and schedule of payments. In other circumstances of deferred contributions, the partnership agreement may provide for a capital commitment/capital call arrangement. In such an arrangement, upon the organization of the partnership, each party makes a commitment to contribute a certain amount of capital to the partnership, but either none or only a portion of the total capital committed is delivered to the partnership at that time. As monies are required for business activities, the managing partner(s) send out a notice to each of the partners stating the timing of delivery and amount required of that partner’s remaining capital commitment.
If property is to be a permissible form of contribution, the partnership agreement must include provisions for the assignment of the property from the contributing partner to the partnership. In the case of intellectual property, sometimes a partner will not complete a transfer of the property but rather only license the use of the intellectual property to the partnership.
Finally, if the partnership permits services as a permissible form of contribution, the agreement must detail the partner’s service commitment to the partnership in exchange for his or her ownership interest in the partnership. The agreement must also deal with the possibility that a partner proposing to provide services in exchange for his ownership interest may fail to provide services as promised. This is regularly handled by subjecting the partner’s ownership to forfeiture for a certain period of time in the event they fail to live up to their promise to provide services. For example, in the event a partner proposes to provide services in exchange for his interest in the partnership, twenty-five percent of such interest will vest upon the completion of one year of services, twenty-five percent will vest upon the completion of a second year of services, twenty-five percent will vest upon the completion of services, and the final twenty-five percent will vest upon the completion of a fourth year of services. The managing partner is sometimes authorized to accelerate this vesting schedule. It is important to note that contributions of services that contemplate vesting schedules come with special Federal tax considerations that must be attended to in a timely manner.
The partnership agreement must also consider the consequence of a partner failing to make a required capital contribution. Often, agreements provide that the defaulting partner forfeits his ownership interest in the partnership. The forfeited interest can then either be sold to a new or existing partner or the benefit of the forfeited interest can be allocated pro-rata among the remaining members.
It is wise to plan for additional contributions to the partnership in the drafting of the partnership agreement. Even if the organizers do not anticipate the need for raising additional capital, it is good business planning to incorporate a mechanism for further contributions from the partners in the agreement. During the drafting process, the partners should consider the method of determining whether additional contributions will be required or voluntary. If additional contributions will be voluntary, how will the partners who elect not to contribute be impacted? Their interests may be diluted. Will the managing partner(s) have sole authority over whether additional contributions are necessary and the amount of the contribution or will the partners vote on these matters? If the partners will vote, will a simple majority carry the day or will eighty percent of the ownership interests be required to make such a decision? The answer to each of these questions will vary from circumstance to circumstance.
Capital Accounts, Allocations of Profit and Loss, Distributions. The partnership agreement must provide that a capital account be maintained separately for each partner. A partner’s capital account represents his equity, or ownership, in the partnership. A partner’s capital account is initially the amount he or she contributed to the partnership. If the partner contributed something other than cash to the partnership, its value should be the initial amount of the partner’s capital account. A partner’s capital account is increased when that partner makes additional capital contributions or receives guaranteed payments (such as a salary) from the partnership and to take into account a partner’s share of partnership income. A partner’s capital account is deceased to take into account distributions of partnership cash and property to the partner and all items of partnership deduction and loss.
The partnership agreement must also determine how items of partnership profit and loss are allocated among the partners. These allocations are governed in large part by Federal taxation law. The Internal Revenue Service has issued a wealth of regulations to guide business attorneys and tax advisors through the drafting and implementation of a partnership’s allocation provisions. This being said, the partnership provides much greater flexibility is allocations of items of profit and loss than does the corporate model. The major concern of the IRS is that allocations of profit and loss among the partners reflect “economic realities.”
Distributions of partnership funds are of a great deal of concern to the members of a partnership. Generally, the purpose of investment in the partnership is to reap the financial benefits of a return on investment. Each partnership must consider how the mechanics of these distributions will work in light of the partnerships activities. Often, a partnership agreement cannot state that the partnership will distribute all partnership income to the partners. The partnership needs monies to fund its activities, whether those activities be solely the payment of operational costs such as salaries, insurance and the like or those activities be further investment or expansion of the business model. Certain partnership investments are highly illiquid in nature and the partners must not expect any distributions for a number of years. This is the model of venture capital firms. Other partnership arrangements do contemplate regular distributions of partnership income. This is normally so in the case of restaurant endeavors; the investing partners expect quarterly distributions of profits. Each circumstance will have its own solution to determining the proper distribution requirements to be included in the partnership agreement. It is wise, if the nature of the business enterprise permits, to provide for distributions to the partners to fund the payment of their tax obligations with respect to their investment in the partnership. For example, Adam owns a ten percent interest in a partnership. The partnership has net income of one million dollars for the tax year. Adam’s share of this income is one hundred thousand dollars. Assuming Adam’s tax rate is thirty-six percent, Adam will owe the IRS thirty-six thousand dollars in taxes from his share of partnership income. If the partnership makes no distributions of profits for this year, Adam still needs to pay his tax obligations to the IRS. In order to avoid such a hardship, partnership agreements often include a mandatory distribution of partnership income to each partner in an amount necessary to satisfy his tax obligations regarding his investment in the partnership. These “tax distributions” often assume that a partner’s tax rate is forty percent. Using the example above, Adam’s “tax distribution” of partnership income would be forty thousand dollars.
Partner, Non-Partner Salaries. The topic of salaries to be paid to partners and other individuals who actively participate in the business activities of the partnership is another important topic that must be considered in the partnership agreement. It is not a good idea to outline amounts in the partnership agreement. This creates rigidity where there need not be. Generally, the partnership agreement should contain a methodology as to how to address compensation issues. Some partnership agreements leave this determination to a majority vote of the partners, while others establish a compensation committee of partners.
Management of the Partnership. The partners must determine how the partnership will be managed. Management can be vested in one manager or a committee comprised of two or more managers. Such a committee may have a group of members each possessing equal powers of management or a hierarchy can be established with each partner being assigned specific duties. For example, a partnership may call for a management committee comprised of three members where the managing partner might have the authority typically vested in the president or CEO of a corporation, the administrative partner may have the powers traditionally associated with the secretary of a corporation and the financial partner may have authority in line with that of a corporation’s treasurer. The partnership agreement should denote who is an authorized signatory to commit the partnership to contractual obligations.
The management portion of the partnership agreement should take into account the time commitment required of each member of management and determine how major business decisions are made. As discussed above, promises not to compete with the business activities of the partnership are often imposed on each partner. Even in cases where this is not so, agreements regularly require promises of non-competition from the members of management. Further, the issue whether members of management will be permitted to engage in outside business activities must also be addressed. Sometimes, the partnership agreement will take into account employee-like issues such as permissible leaves of absence, vacations and sick leave.
The majority of day-to-day decisions regarding the business affairs of the partnership should be made by management, but issuing involving the entire character of the business of the partnership are commonly made by a vote of the partners. Issues of this nature include whether to take on a substantial debt obligation, cease operation of one or more partnership lines of business, sell substantially all the assets of the partnership, dissolve the partnership, etc.
Items relating to partnership finance and accounting should be set forth in the partnership agreement in considerable detail. The manner in which books and records of the accounts and business transactions are maintained should be outlined so that management is clear as to their fiduciary obligations to the partners. In addition, this section of the agreement should direct how the person administering the partnerships finances should handle his or duties, including the deposit of monies and other valuables in the name of the partnership and disbursements of partnership funds.
Meetings of Management, Partners. The frequency of meetings of management is an important area of concern in a partnership agreement. The agreement should provide for adequate prior notice, permissible locations, whether telephone or other electronic mediums are permissible forms of attendance, quorum, who will preside, whether non-managing partners are permitted to attend, etc. If the partners determine that they should have meetings whether annual or otherwise, the considerations noted above are also applicable to partner meetings.
Maintenance of Partnership Records. In addition to the maintenance of the financial records discussed above, the partnership agreement should take into account the maintenance of the other substantive and ancillary books and records of the business of the partnership. It is wise to include a provision stating that the books and records of the partnership are available for inspection by the partners at reasonable times and that the partners have the right to audit the books and records of the partnership.
Business Assets. The partnership agreement should state whether or not all the contributed business assets of the partnership are available for sale in the pursuit of the partnership’s business objectives or upon dissolution. If this is not the desire of the partners, the agreement should detail the how the business assets may be disposed of. For example, Brett contributes cash to the partnership. Calvin contributes commercial property with the condition that in the event the partnership wishes to dispose of the property or the partnership dissolves, Calvin has first priority to repurchase the property from the partnership.
Transfer of Partner’s Interests. The transfer of a partner’s interest in the partnership upon the occurrence of certain events should be considered in a number of circumstances. If the partnership is merely an investment vehicle, it may not matter who owns the partnership interest. A partner who becomes permanently disabled can continue to own his partnership interest and reap the benefits of a return on his monetary investment. The interest of a partner who dies can be passed to his heirs. However, in a partnership that requires the active participation of the partner who is affected by a certain event, such as bankruptcy, death, disability or retirement, such event often requires the transfer of the interest to one or more existing or new partners who can participate in the activities of the partnership. The alternative is that the partnership redeems the departing partner’s interest and each partner shares in that beneficial interest on a pro-rata basis.
The fact that a partner may want to voluntarily transfer his interest in the partnership should also be taken into account. The partnership agreement should limit free transfer of a partnership interest. The individuals organizing the partnership intend to commit to a business enterprise with one another; however, it is unlikely that they would be willing to commit to the enterprise if each partner is permitted to transfer his or her ownership interest and participatory obligations to an unrestricted class of persons. Quite often, a partnership agreement provides that at a minimum, the management of the partnership must approve such a transfer. It is also common for a partnership agreement to require that the partner wishing to transfer his or her interest first offer to sell the interest to the partnership and/or the remaining partners. This is referred to as a “right of first refusal.” Further transfer rights and obligations also bear some consideration. For example, Dennis, one of the founders of the partnership who holds a significant percentage interest in the partnership, determines that he wishes to transfer a majority of his interest and the management of the partnership approves the transfer. However, the remaining partners possess a “right of co-sale.” This means that each partner possesses the right to piggy-back on Dennis’ sale of his partnership interests on a pro-rata basis selling a certain percentage of their own interests along with the interests proposed to be sold by Dennis. The calculation of how much of Dennis’ transferrable interest is reduced and replaced by the other partner’s interests is determine by a formula set forth in the partnership agreement.
Many partnership agreements contain buy-sell provisions, requiring one or more partners to buy-out another partner in certain circumstances such as bankruptcy, disability, divorce, retirement, etc. It is important for these provisions to include valuation methods to determine the purchase price for the partnership interest to be transferred. Partners should also consider including a mechanism in the partnership agreement as to how purchase obligations will be funded. Often, partners will be required to purchase life insurance policies on the other partners to the partnership.
Regardless of what transfer restrictions are put in place, the partnership agreement must include a process for the admission of new partners in the event that a partner’s interest is in fact transferred outside of the original ownership group.
Termination, Dissolution. A provision for the continuation or termination of the partnership upon the leaving, death or dissolution of one or more partners should be considered. If the partnership is comprised of a number of partners who contribute interchangeably to the business of the partnership, it may acceptable to the remaining partners to continue with the enterprise. On the other hand, if the business of the partnership is based solely on the contributions of one or two partners with unique and irreplaceable abilities, it may not make sense to discontinue operations and dissolve the partnership.
General Provisions. Finally, the partnership agreement should take into account such boiler plate matters as mediation and arbitration, the procedure for amending partnership agreement, governing law, notice, severability, construction, etc.